Description

Trex
TWP $38.75, http://www.trex.com)

Overview
Trex is the pioneer in the manufacture of decking and railing products from reclaimed wood and plastic. The company was formed in 1996 by four executives from Mobil and brought public in 1999. Annually, Trex purchases about 300 million pounds of used polyethylene (garbage bags, pallet wrap, etc) and an equal amount of recycled wood (sawdust, wood scraps, etc) to process through its manufacturing plants in Winchester, VA (headquarters) and Fernley, NV. The primary advantages of the composite are its longevity, never rots, cracks, splinters, weathers, or needs stain. The partially patented process is easy to install and is used by consumers and contractors throughout the U.S for decking. It is not approved for joist or other supports. Local retail price checks per board (2X6X12) are $20-$23 vs. $5-$6 for treated lumber. Recently the company introduced Trex Accents, their first grained product. In December, the company announced plans to build a third manufacturing plant in Olive Branch, Mississippi. There have been significant insider sales of common stock over the last 6 months (455,000+ shares) with no insider purchases. Insiders own over 50% of the company; three of the four principal shareholders have retired recently.

The Industry*
Over 50 million homes have pressure treated wood structures. It is a $4 billion dollar a year business. About 90% of all decks are made from treated lumber. Ending December 31st, the popular form of lumber known as CCA-treated (chromated copper aesenate) was phased out over the last 22 months due to EPA concerns over arsenic as a toxic ingredient. A new preservative marketed as Preserve by Chemical Specialties Inc. is made with copper and the fungicide quaternary. In short, it's called ACQ-treated lumber. "It will do the same thing as pressure-treated lumber," says Jim Graves, sales and operations manager at Treated Lumber Outlet in Hampton, VA. The negative of ACQ-treated lumber is that it requires galvanized fasteners. Other alternative products are plastic lumber, cedar, and several other expensive imported woods.

Operating Results
Trex’s revenues in 2000 and 2001 were both about $117 million while jumping to $167million in 2002. Revenues are expected to finish at $192 million for the trailing twelve months. For 2004, analysts are expecting $250 million in revenues, up 30%!

Operating earnings are $20.3 million or $1.38 in EPS for the trailing twelve months (ttm). There are 14.7 million shares outstanding with a market cap of $565.7 million. The total enterprise value is $594.81 and tangible assets are $120 million. The key ratios are as follows: price to sales 2.6X (ttm), prices to cash flow 15.6X (ttm), price free cash flow 36.4x (ttm), price to book value 4.2X, and a PE ratio of 24X (ttm). Gross margins are 45% while the net profit margin is 10.9% (ttm).

Opportunity
I have been patiently following the company since the IPO and have looked at various opportunities to go long or short. The biggest shocker came in the Sept 30th quarter when the company missed forecast blaming it on the weather. It is important to note the sales pattern of the business (ttm): 36% sales come in the 1st qtr, 31% in the 2nd, 22% in the 3rd qtr, and 10% in the fourth. Therefore, the December quarter reported today after the close is the easiest quarter and I wouldn’t expect any surprises. The key is the guidance/results for the 1st and 2nd quarters of 2004.

We all know the flaws of Wall Street research. In most cases analyst are parrots for the company and do little outside research. If they dare speak to competitors, distributors, or even ex-employees it would hamper their relationship with the company and knock the firm out of investment banking opportunities. Therein lays the opportunity for truth seekers: what happened in the September quarter and how is the current booking for March quarter?

Even though Trex is the pioneer of the industry, there are several competitors that have successfully emerged: Weyerhaeuser/ AERT Inc’s ChoiceDek Plus Line (http://www.choicedek.com), Louisiana-Pacific’s WeatherBest (http://www.lpcorp/com), Tendura (http://tendura.com), Xtendex (http://www.xtendex.com), Crane Plastic’s Timbertech (http://www.timbertech.com) , ChoiceDek (http://www.choicedek.com ), Perma-Wood (800-291-5300), Dream Deck (800-245-1540), Phoenix Plastic Lumber (800-888-0880), Nexwood (http://www.neexwood.com) , Perma-Poly (http://www.renewplastics.com ), etc. These companies offer an array of product assortments (different grains, tongue and grove, colors, cone structure for lighter weight, etc). Investigative conversations with these companies indicate they were not affected by the weather in the September quarter, and that they are growing and gaining market share. Therefore, Trex is no longer the kingpin of the industry. Further conversations with ex-Trex employees, distributors, and retailers indicate an array of points. Ex-employees claim that competitors are gaining market share. Retailers indicate that Trex is weak in customer service and were late to market in railing and grained products. Most importantly, field checks indicate that first quarter bookings are only up 8-12% for the majority of Trex’s competitors; while Wall Street expects an increase of 25%! Also, there is not an overwhelming demand for the new Trex Accents line and there has been talk of price cuts.

Conclusion
I typically like to short companies that have a chance to go down 80-100% over the course of time or trading opportunities that have a specific catalyst with good risk/reward. Trex fits in the latter, either they will guide analysts down on the release/call (call next day Feb 24th 11:00AM, Ph. 888-803-7566) or they miss the first quarter estimates in the next 60 days. Expectations are for a loss of $.07 for the December quarter, mid $.70 range for the 1st quarter (actual consensus is .83 but includes an outlier of .93 that skews the mean), .65 in the second, and $1.88 for year. Revenues are expected to be up 25+% in the first quarter and 30% for the year, yet margins will come under pressure from the advent of competition and competitors gaining market share. The stock has traded in a 52-week range of $28.20-$45.00, and traded below $30 intra-day on the September 30 earnings guidance. At 15X cash flow, the stock could easily trade into the mid to high 20’s on flat to slightly higher guidance. An investor relation is not management’s greatest strength.

Risk
This trade is not without risk. The company could land a substantial contract with a large retailer. Lowe’s sells Weyerhaeuser’s product and Home Depot recently announced a product produced by Fiberon/Universal Forest Products. The demand could sharply increase for composite decking. The decking market is growing at 3-4% a year with 10% represented by composites. The short interest is big! The short interest of 2.3 million shares is 12.8% of the outstanding shares or 29% of the float.



*Footnotes
http://www.usatoday.com/news/nation/2003-12-29-treated-lumber_x.htm
http://www.yourlawyer.com/practice/printnews.htm?story_id=5119

Catalyst